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Chapter 11
Fiscal Policy: The Keynesian View
and Historical Perspective
OUTLINE
I. The Great Depression and Macro-Adjustment Process
A. The Great Depression and Keynesian Economics
2. Keynesian theory provided an explanation for the severe and prolonged
unemployment of the 1930s.
3. Keynes argued that wages and prices were highly inflexible, particularly in a
4. Keynesian View of Spending and Output
a. Keynes argued that spending induced business firms to supply goods and
II. Output, Employment, and Keynesian Economics
A. The Multiplier and Economic Instability
2. Spending of one party increases the income of others. Thus, an increase in
spending can expand output by a much larger amount.
B. Adding Realism to the Multiplier
1. In evaluating the importance of the multiplier, one should remember:
a. An increase in government spending will require either higher taxes or
additional government borrowing.
normal times.
2. During normal times, the demand stimulus effect of additional spending is
substantially weaker than the multiplier suggests.
C. Keynes and Economic Instability: A Summary
1. According to the Keynesian view, fluctuations in total spending (AD) are the major
source of economic instability.
2. Keynesians believe that market economies have a tendency to fluctuate between
3. The multiplier concept magnifies these fluctuations.
III. The Keynesian View of Fiscal Policy
A. Budget Deficits and Surpluses
1. Budget deficit: present when total government spending exceeds total revenue
from all sources
2. Budget surplus: present when total government spending is greater than total
revenue
3. Changes in the size of the federal deficit or surplus are often used to gauge whether
fiscal policy is stimulating or restraining demand.
4. Changes in the size of the budget deficit or surplus may arise from either:
5. The federal budget is the primary tool of fiscal policy.
6. Discretionary changes in fiscal policy: deliberate changes in government spending
and/or taxes designed to affect the size of the budget deficit or surplus..
B. Fiscal Policy and the Good News of Keynesian Economics
1. Keynesian theory highlights the potential of fiscal policy as a tool capable of
reducing fluctuations in AD.
2. Prior to the Great Depression, it was widely believed that the government should
balance its budget. Keynesians challenged this view.
3. Keynesian Policy to Combat Recession
4. Keynesian Policy To Combat Inflation
a. When inflation is a potential problem, Keynesian analysis suggests fiscal policy
should be more restrictive.
IV. Fiscal Policy Changes and Problems of Timing
A. Various time lags make proper timing of changes in discretionary fiscal policy
difficult.
1. Discretionary fiscal policy is like a two-edged sword; it can both harm and help. If
timed correctly, it may reduce economic instability. If timed incorrectly, however,
it may increase rather than reduce economic instability.
B. Automatic Stabilizers: without any new legislative action, they tend to increase the
budget deficit (or reduce the surplus) during a recession and increase the surplus (or
reduce the deficit) during an economic boom.
1. Unemployment Compensation.
3. Progressive Income Tax.
D. Paradoxes of Thrift and Spending
1. The paradox of thrift
a. The paradox of thrift: The idea that when a large number of households
increase their saving and reduce consumption, their actions may reduce
aggregate consumption and throw the economy into a recession.
b. Keynesians often stress the dangers implied by the paradox of thrift and
excessive saving.
2. While an increase in consumption might temporarily boost AD, households will
4. You cannot have a strong and healthy economy when households are heavily
indebted and face persistent financial troubles because their saving rate is low.
5. Household debt and the 2008-2009 Recession
a. The historically high level of debt meant households were in a weak position to
deal with the recession of 2008-2009.
ONLINE ADDENDUM:
V. The Keynesian Aggregate Expenditure Model
A. Basic Keynesian Model
1. Aggregate expenditures = Planned Consumption + Investment + Government
Expenditures + Net Exports
2. In the Keynesian model, as income expands, consumption increases, but by a lesser
amount than the income increase. Both planned investment and government
B. Keynesian Equilibrium
1. In the Keynesian view, equilibrium takes place when planned aggregate
expenditures equal the value of current output. When this is the case, businesses
2. When total expenditures are less than current output, business firms will
3. When total expenditures are greater than output, inventories will fall and
4. Keynesian Equilibrium can occur at less than full employment. When it does, the
C. Aggregate Expenditure and AD-AS Models
1. The AE model implies that increases in demand will expand output until full
employment is reached.
2. Once full employment is reached, the AE model implies that additional demand
will lead only to a higher price level.
3. An important implication of Keynesian analysis within the AD-AS framework:
a. When substantial idle resources are present, increases in AD will lead primarily
4. Keynesian Equilibrium can occur at less than full employment. When it does, the
high rate of unemployment will persist into the future.
OBJECTIVES
This chapter focuses on fiscal policy, one of the two macroeconomic weapons available to policy
makers. In recent years, macroeconomists have reevaluated both the potential and limitations of
fiscal policy. The impact of fiscal policy is a major point of controversy among macroeconomists.
This chapter presents the Keynesian view and provides an historical perspective of the development
of macroeconomics.
IMPORTANT POINTS AND TEACHING SUGGESTIONS
2. Exhibits 2 and 3 present the Keynesian view of counter-cyclical fiscal policy. As Exhibit 1
illustrates, Keynesians believe that the self-corrective mechanism of a market economy works
3. Be sure to emphasize that the Keynesian view implies that economic conditions replace the
concept of a balanced budget as the measuring rod for the determination of prudent budgetary
4. Critical Analysis question 1 provides both an interesting and useful homework assignment. The
5. Be sure students see that the crucial underlying issue in analyses of the government deficit is
are better spent than they would otherwise have been, the deficit has facilitated an improvement
HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS
4. A budget deficit is a situation in which total government spending exceeds total government
revenue during a specific time period, usually one year. When this happens, the government
8. Tightness in resource markets will result in rising resource prices relative to product prices,
causing the SRAS to shift to the left. Profit margins will decline, output rates will fall, and
10. Keynesians would favor the sending of checks to households which were financed by debt.
Most Keynesians believe the market-adjustment method of lower resource prices to increase